On October 19th, Joel Greenblatt, the author of The Little Book that Beats the Market and the father of Magic Formula Investing (MFI), gave a presentation to the Value Investing Congress concerning the Magic Formula and his related venture, Formula Investing. There was some interesting data and questions during the presentation that are of interest to any MFI adherent. Check out the video and related slides at the links below:

Greenblatt started his presentation by addressing what was actually wrong with the strategy. For MagicDiligence readers, the answers are nothing new. For one, the EBIT used for earnings yield is a past figure that may not be indicative of future profits. Examples he provided included fad stocks, cyclicals, and companies that may have reached an earnings peak (dying companies). I would also add to that companies that have large near-term debt obligations without the cash to cover them.

Another point he makes is that the important thing is returns on future capital, not necessarily past capital. Can a stock reliably earn the same returns on capital going forward while growing the business? That is the key question. In a nutshell, the biggest "problem" with MFI is that it looks at the past, not the future.

Updated Performance Since 2004

The Little Book that Beats the Market's back-test stretched from 1988 to 2004, in which it returned 30.7% annually, an amazing figure. Greenblatt took the stage to update MFI results from the interim, and they were similarly stellar. From 2005 through the end of September 2009, MFI racked up an annual average return of 12.0%, vs. the S&P 500's 1.7%, a massive 10.3% annual outperform. This tells us that, despite the strategy having been public for 5 years now, it still works and works very well.

Greenblatt also reiterated that it doesn't always work, citing a 34-month and 13-month period in the last 10 years where it underperformed the market. This is why he believes the strategy is safe from overexposure - people just don't have enough patience to stick with it when it isn't working. I've seen this first-hand in the MFI Internet community.

Greenblatt was somewhat coy in his response. He started by naturally pointing out that 99% of investors do not know how to analyze a business and determine how much it is reasonably worth. He also says that there are usually always problems with MFI stocks, else they wouldn't be cheap enough to be screened. In fact, Formula Investing was started because people were having trouble choosing which stocks to buy.

However, there were some concessions too. Greenblatt did concede that using it as a screen for research was valid, and that it could be possible to find stocks where the "problems" were unlikely to be of major concern. Also, interestingly, he conceded that if he did have data indicating that research would improve the strategy, he may not be as open to sharing that!

Overall, the presentation does nothing but reiterate and excite me for the potential future returns of Magic Formula investors. I believe we can improve the strategy by finding the "Magic Formula mirages" like Maxygen (MAXY), which is down 33% against the market's 37% rise. And then also finding stocks that can grow and earn their past returns on capital, like Polo Ralph Lauren (RL), which is up 100% vs. the market's 42%. MFI is a great strategy, and MagicDiligence is here to enhance it for followers.

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